January 6, 2013

The last Recession Watch update we issued was in September, 2012. That update took the model from a 45% probability of a recession within the next 6 months, to 55% probability. Today the model is telling us that the risk of recession sometime in the next 6 months has lessened somewhat, to 40%. What caused the model to change, and what, if anything, should you do about it?

On New Year’s Day, Congress finally reached a deal that will avoid the bulk of the fiscal cliff. This means the US economy will experience only a very limited fiscal drag and fears of a recession will likely recede. However, policy uncertainty remains, as further negotiations on the debt ceiling and sequester spending limits will have to take place during the first quarter.

The way the model is constructed, readings between 20% and 80% are dominated by noise. It’s only when the reading gets into the “red zones” at either end of the scale that you should consider taking bold action.

When the indicator reaches 80% or higher, caution is advised for equities. I recommend cutting equity exposure in half at that point. When it declines to 20% or less, I recommend aggressive allocations to equities. And when it reaches 95%, I recommend a zero allocation to equities.

With the reading moving from 55% to 40%, very little action is called for. For very active investors, some incremental adding to equities would be fine, but not required. The model portfolio went from neutral weight in equities, to slightly overweight. If you have new cash coming into your portfolio during the next few months, you can add to your equities until you get to about a 2% overweight relative to your benchmark allocation.

If no change to your portfolio is required, then why publish this note at all? Because each of us interprets these kinds of signals in a slightly different way. At what point would I be likely to recommend a more active response? If our fearless leaders in Washington allow partisan politics to cause a serious policy mistake, I will become very concerned. But we can expect more posturing, brinkmanship, and hostage-taking along the way.

These dangerous games will cause sharp declines in the equity markets, but they are unlikely to cause permanent harm. If serious policy mistakes are made, though, it will show up in the recession model and I will issue another alert.

Erik Conley

About the author 

Erik Conley

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

{"email":"Email address invalid","url":"Website address invalid","required":"Required field missing"}